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The US Federal Reserve (Fed) has just raised interest rates for the third time in a decade, in a significant acceleration of the pace by which it is tightening monetary policy. We believe further rate hikes are on the way – and at a faster clip than the market expects.

Since the election of US President Donald Trump, financial conditions have eased considerably, due to the former reality TV star’s pledges to splurge on infrastructure and cut financial regulations. By some estimates, this has had the same impact as a 0.75% cut to US interest rates.

As such, when deciding whether to tighten or loosen policy, financial conditions should play a large part in the Fed’s process. Failure to do so can lead to policy mistakes that inadvertently stoke a large expansion in credit and a permanent loss of economic output, relative to the medium-term trend.

In the years before the crisis, for example, the Fed allowed excessive leverage to build up in the economy by keeping interest rates too low due to its fixation on inflation rather than credit. Yet inflation provided a false signal, because the fall in the value of tradable goods from Asian manufacturers and various other factors kept prices low.

Against a backdrop of rising credit creation and climbing house prices today, there has been a shift in tone from Fed officials of late, indicating that some lessons have been learned from the monetary guardian’s policy stance during 2004-2007.

We are not surprised, therefore, that the Fed tightened policy today and we expect more rate hikes later this year. Markets estimate about two hikes this year; as the Fed, mindful of its past errors, will probably seek to lean against the looser financial conditions, this appears too low in our view.

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